Index Fund Fingering

As the curiously low-profile investigation into mutual fund mismanagement proceeds apace, regulators are talking about more tightly policing differences in index funds, which seek to track large segments of a given industry or market measure (such as the S&P 500).

There's variance in the fees companies charge to maintain these funds, which are usually passively managed, meaning they don't really have hugely different cost structures to operate (unlike actively managed funds, where managers buy and sell a lot of stocks). From a NY Post account:

According to Morningstar, Inc., which monitors fund companies, the Vanguard 500 Index charges customers 0.18 percent of assets annually. But the Scudder S&P 500 stock fund levies as much as 1.8 percent as a fee.

"There can be quite a bit of difference. Whether there should be is an open question," said Jeffrey Ptak, a mutual fund analyst with Morningstar. "There isn't any reason I can think of."

One reason that should be sufficient is that investors knowingly tolerate such differences--Vanguard's low fees are its main advertising point. It may not be "rational" in any grand sense to buy an index fund with higher fees, but it's still meaningful to some people, especially when seemingly identical products may be subtly different. Why does anyone buy brand-name aspirin when generic is by most accounts just as good? There's a service component and a comfort component that is always highly subjective. Even when people may seem to be acting stupidly or wrongly (another subjective categorization), there's a lot to be said for letting them do so in consumer situations. Indeed, letting people spend their money the way they want to is basic to any free society.

But there's reason to believe that the focus on index funds--where nearly identical products are unders scrutiny--is really one more way to set the stage for more tightly regulating fees in mutual funds for more disparate products (fees are already heavily regulated, as is everything in the securities industry).

Why is it OK to set a rate for index funds, but it's not OK in other areas?" asked Geoff Bobroff, a mutual fund consultant with Bobroff Consulting. "It is one of those curious questions."

Comments

[Jason Ligon]

elliot:

No but Bank A can charge you a lower rate than Bank B, and if you choose Bank A, you have made your bed. Why do we need the government to tell us what the rate is 'supposed' to be?

[J Mann]

Well, my 401(k) lets me buy Scudder but not Vanguard, so I care, but I suppose I should be complaining to my plan administrator, or to the government for setting up the 401(k) system in the first place.

[Mark Fox]

elliot: Banks, or anyone, should be free to set prices however they choose. Each buyer can select according to perceived value. Why delegate the responsibility of the purchaser to the state?

[John B.]

Why different fees?

For one reason, Vanguard has a higher investment level than T-Rowe. So, there would seem to be a lower cost fo Vanguard...bigger, and therefore, fewer transactions in and out. T-Rowe allows smaller initial investments and smaller subsequent buys, causing more transactions (which cost money).

Here is an idea, why not let me figure out what is the best way to invest my money. Perhaps by lowering fees, T-Rowe or others will raise the minimum amount to buy, causing some people to be unable to buy. Hmmm, but the market place takes care of that.

Wow, you mean, left alone, the market will price things differently when they are of different value to a consumer. Why, that almost sounds like something they should teach in economics or something.

Perhaps Mr. Ptak, at Morningstar might wonder what the market knows that he does not. Oh, or is it just that collectively, the market knows all, more than even Morningstar.

Must get the duct tape....

[Jason Ligon]

"Well, my 401(k) lets me buy Scudder but not Vanguard, so I care, but I suppose I should be complaining to my plan administrator, or to the government for setting up the 401(k) system in the first place."

Gripe to your benefits department, and thow the phrase 'fiduciary responsibility to control participant costs' around a lot.

[Jason Ligon]

Interesting side note on Slate, linked through Marginal Revolution.

http://slate.msn.com/id/2458/#ContinueArticle

Summary: Index investors are freeloaders. The index is a commons that has value only because some people actively seek high returning securities. Index funds free ride on the work of others, then use their lack of significant management fees to undercut the actively managed funds that created the value in the index in the first place. The problem is, the more people go to index investing, the less value the index holds.

[Ken]

elliot:
Stupid people are often charged more in many venues. Remember that "A fool and his money are soon parted". LOL

[Russ]

Jason,

The index investor is less of a "freeloader" and more a believer in the efficient market hypothesis.

Actively managed investments don't give value to securities, instead they arbitrage market prices to align prices and valuations. This process makes markets more efficient.

Index investors accept that the going market price is pretty fair, and the costs of research to find a better bargain would exceed the benefits. This is the same reason that most people don't bargain at the grocery store, or spend much time comparing prices between different stores. They accept that the prices at the market are pretty good, and the search costs would outweigh the benefits. Does that make them freeloaders?

That said, I don't own index funds because I believe that markets are more irrational than efficient.

[Andy D.]

Jeff Smith... I'm curious to know if the subjects knew whether they were getting generic or brand name aspirin. If so, could the different effectiveness be explained away by a placebo affect having to do with people believing the brand name aspirin is superior? I mean, if "brand name placebo" was superior to "generic placebo"... well, then you've already pointed out a placebo effect for "brand name".

[Jason Ligon]

Russ,

Hypothetically, what happens if every investor is an index investor?

I think the case for investors to use index funds for their own benefit is quite good (as made in "A Random Walk through Wallstreet"). Fees are low, most funds don't beat benchmarks, etc.

However, stocks are placed on an index because of their performance, and their performance is a price. What happens to the apple market if everybody in the world mechanistically buys the same quantity of apples every year, all other factors be damned?

[Russ]

Jason,

Even in a market that was dominated by index investors, the few active investors remaining would keep prices in line, while reaping some major profits doing so.

Remember, the active investors are competing against each other for arbitrage profits. The passive investors are acting as price takers. The fewer active investors there are, the more profits the remaining ones make. The prospect of arbitrage profits will attract enough players to the active side of the business to keep things running.

[Stephen Fetchet]

Is it possible that the reason it is curiously low-key is to avoid creating an investor panic?

It seems to me like the best way to completely screw up a company's stock value is to announce that Elliot Spitzer has decided to investigate it. Regardless of wrongdoing, the announcement would do a pretty good job of deflating the company's stock.

How much more true is this, where an entire sector of the stock market is under investigation?

[Jason Ligon]

Regulation in securities is very paternalistic. I can almost sympathize in some ways. People just do not have the slightest understanding of the products they are purchasing.

I hear people all the time saying that their insurance company is going to 'guarantee' them a rate of return with no fees. It is patently illegal to guarantee against loss, and when you really look at the annuity products these guys are selling, even the fee piece is a lie.

You have a product that is sold by scaring granny, and it is so complicated that no granny knows what they have or how much they are paying for it. It is as though you were shopping for a car for an unknown amount (oh, that's not a FEE, it's a CHARGE, you didn't ask about that), and you didn't know that a car was supposed to have four wheels.

Regulating the price of an index fund seems silly to me, and it is definitely dangerous. More people should utilize the services of an independent fee for service advisor. It is the market way to avoid this sort of problem.

[Tim Cavanaugh]

The strange thing here is that Vanguard not only offers a lower fee but a higher brand recognition as well. So it's doubly strange that anybody without a prior customer relationship with Scudder would pick their index fund over Vanguard's. I won't choose Vanguard because I used to cover them and I really grew to hate their flack. T Rowe Price roolz!

[Jef Smith]

In grad school I read a paper in Lester Telser's
class that did a random assignment clinical trial
with four treatments:

branded aspirin
unbranded aspirin
branded placebo
unbranded placebo

The four treatments were effective in the order
listed for headaches and, with the effects
statistically different at standard levels of
significance.

Brands matter.

Jeff

[eli]

The SEC should just get it over with and outlaw the securities industry. That's where they're headed, a little bit at a time.

[Douglas Fletcher]

I don't know enough about all this to know if this is relevant or not, but maybe what discussed in this link (software for picking stocks) will make all these index funds obsolete.

http://www.nationalreview.com/nrof_glassman/glassman200401290906.asp

[James B.]

Tim,

I am curious about your experiencese with Vanguard and their "flack". I have all my money with them. I live in Chester County, PA,(Vanguards' home) and have never heard anything bad about them, except from commissioned sales people selling other funds.

[elliot]

So, banks should be allowed to charge higher interest on loans to stupid people?

[Rob]

Doug,

I would be more impressed by the article you posted if the author had said anything at all about the volatility of returns in the portfolios he's touting. It makes all the difference in the world.

For (exaggerated) example, say you can pick from two funds, A & B. A has returned 20% over the last 3 years, with a volatility of 50% per year. B has returned 10% over the same period with volatility of 10%. Which one is best? All depends on your appetite for risk.

One of the funds in the article (Cornerstone something or other) has a Sharpe ratio (return above risk-free-rate divided by volatility) of .72 (from Yahoo Finance) which is extremely impressive. I'd be curious to know the ratio of the other computer-picked portfolios...

[Certified Cars]

I am so happy with the used car I bought online, and I saved a ton of cash!

[Rob]

If you guys want something to complain about, here's a mission:

Find out if your 401(k) administrator is engaging in "fee arbitrage" with your retirement money. An example (from above) would be offering only the Scudder SP500 index fund to you at 180 bps a year. You invest, but they don't buy Scudder's SP500 fund. Oh no, they actually buy Vanguard's, and they pocket 160 bps on the trade.

It happens. My previous employer, which is under investigation by Mr. Spitzer, no less, engaged in this slimy practice. Effectively, they're forcing you to take their credit (which would be required if the return on Fund A is drastically different from the return on Fund B), and you get to pay them for the privilege.

[Sport Utility Vehicles]

I saved over $5,000 when I bought my new SUV online. I am so happy that I wanted to spread the word. Sorry if the message is not welcome.

[Jeff Ptak]

I just wanted to take a moment to reply to John B's comment above.

Nowhere have I or anyone else at M* suggested that the market isn't intelligent. It is what it is. What we are asserting is that the market for index funds isn't as frictionless as the commodity-like nature of the offering might suggest. Why? Because mutual fund boards have failed to do their part in negotiating fees with the advisor for the benefit of fund shareholders. In addition, informational inefficiencies--namely, lack of investor education--also create friction. That friction is compounded when brokers exploit their less-than-astute clientele by placing them into index funds that have essentially been defanged by their lofty expenses.

Now, the questions of whether lax board governance or shady advisor practices constitute a breach of fiduciary duty remains open. What's indisputable, however, is the notion that people who invest in these high-priced funds are getting totally hosed.

There's little doubt that investors are going to have to pay a premium when using an advisor. They provide a legitimate service which, when offered in good faith, adds real value. Hence the generic versus brand name comparison. HOWEVER, let's get real for a second: Putting an investor in an index fund isn't exactly a heroic feat. What's more, servicing the account--which 12b-1 fees typically subsidize--shouldn't require a ton of time or effort. Yet, there are a passel of front-loaded funds that have 25bp annual 12b-1 levies attached. What's more, there are a few B-shares that are unquestionably more expensive than their A-share siblings, yet have gathered billions in assets. Those excesses can't be chalked up solely to investors willingness to pony up for the 'brand name'. What's more, I have to question, at a fundamental level, the fiduciary duty of an advisor who would allow a client to pay up for an index fund. It strikes me as a self-defeating proposition: I look out for your best interests by putting you in an offering that by definition doesn't have your best interests at heart. That's not a brand-name premium. It's price gouging.

With respect to fee regulation generally, I personally am opposed as it's contrary to the spirit of the Investment Act of 1940. That is, vigorous board of directors--which put the advisor's feet to the fire when negotiating fees--and greater transparency of fees should go a long way towards bringing expenses down. The SEC's recent investigation into index funds is remarkable in that it offers a stark look at the perversion of a system that has become wedded to the status quo. In addition, it telegraphs what I think will be more substantive, long overdue efforts on the Commission's part to hold boards accountable. They're fiduciaries after all. It's time for them to act the part.

If you've made it to the end of this treatise, you deserve a medal.

Thanks for reading.

Jeff Ptak
Morningstar, Inc.
Mutual Fund Analyst